I'm a private money manager and freelance writer focused on Peak Oil and Climate Change as investment themes. I manage portfolios for individual clients and am co-manager of the JPS Green Economy Fund, a hedge fund open to accredited investors looking for exposure to Peak Oil and Climate related themes. I no longer write for Forbes, but I'm Editor at AltEnergyStocks.com, where I've been analyzing clean energy stocks since 2007. I live in Upstate New York, and am a runner and a woodworker. Since I write for several sites, you can follow me on Twitter, where I tweet new articles and links to other things that catch my eye on the web. DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This blog contains the current opinions of the author and such opinions are subject to change without notice. Blog entries are distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

The End Of Elastic Oil

The last ten years have brought a structural change to the world oil market, with changes in demand increasingly playing a role in maintaining the supply/demand balance. These changes will come at an increasingly onerous cost to our economy unless we take steps to make our demand for oil more flexible.

We’re not running out of oil. There’s still plenty of oil still in the ground. Oil which was previously too expensive to exploit becomes economic with a rising oil price. To the uncritical observer, it might seem as if there is nothing to worry about in the oil market.

Unfortunately, there is something to worry about, at least if we want a healthy economy. The new oil reserves we’re now exploiting are not only more expensive to develop, but they also take much longer between the time the first well is drilled and the when the first oil is produced. That means it takes longer for oil supply to respond to changes in price.

In economic terms, the oil supply is becoming less elastic as new oil supplies come increasingly from unconventional oil. Elasticity is the term economists use to describe how much supply or demand responds to changes in price. If a small change in price produces a large change in demand, demand is said to be elastic. If a large change in price produces a small change in supply, then supply is said to be inelastic.

Elasticity of Demand

On the demand side, the elasticity of our demand for oil reflects the options we have to using oil for our daily needs. At a personal level, we can quickly cut our demand for oil a little bit by combining car trips, keeping our tires properly inflated, etc. But the ability to make such reductions is often limited, and even such simple measures come at a cost of time or convenience, which is why we’re not doing them already. If we live in an area without good public transport (as most of us do) we can’t stop driving to work without losing our job, so we keep driving to work, and paying more for the gas to get there.

Over the longer term, our personal options to cut oil consumption increase. We can move closer to work, or to somewhere where we can walk or use public transport to get to our job. This is why the most fuel-efficient vehicle is a moving van.

Replacing a car with a more fuel efficient vehicle is an option for those who have money or credit, but the people who are under the most pressure from high fuel prices are unlikely to be able to afford such options. If they can’t resort to ride sharing or public transport, they may simply lose their jobs because they can’t afford to get there.

The reduction in fuel use that comes from people losing their jobs and no longer commuting to work also contributes to the elasticity of demand, and I mention it to highlight the point that while reductions in fuel use can be benign (properly inflated tires, for instance), they can also be harmful to the economy. Reductions in demand due to high prices are often called demand destruction, and it’s just as unpleasant as it sounds.

Elasticity of Supply

Since our options for reducing oil demand in response to rising prices range from inconvenient to expensive, to downright painful, it’s clear why the media and politicians focus so much attention on the other half of the equation: When supply adapts to changes in demand, voters don’t have to make uncomfortable choices.

But there are also limits to the ability of oil supply to adjust. Most OPEC nations, including Saudi Arabia, need at least a $100/bbl for oil to keep their budgets in balance, so why would they increase production to reduce the price below that? In fact, as (subsidized and hence inelastic) OPEC domestic consumption continues to increase faster than supply, OPEC net exports will continue to fall, further raising the price needed to balance exporters’ budgets.

While fiscal issues constrain OPEC’s elasticity of supply, geology and politics constrain oil supply elsewhere. Brazil’s giant pre-salt fields, like deep water discoveries in the Gulf of Mexico and elsewhere, are much more expensive and slow to develop than were past discoveries. Canada’s tar sands are large mining operations, and are similarly slow and expensive to develop.

Put simply, if the oil were quick and easy to get at, we’d have gotten it already. All these factors mean that the elasticity of oil supply is falling, so oil demand has to adjust more in response to changes in price than in the past.

Data

Since there is little reason to assume that the elasticity of oil demand has changed significantly (do we have more options for doing without oil than we did ten or twenty years ago?) while the elasticity of oil supply has fallen, we have to expect that overall oil price elasticity has fallen as well, and these changes should show up in oil market data.

Using oil annual supply, price and consumption data from the EIA and IEA, and making some back-of the envelope adjustments to account for the difference between their different definitions of what constitutes oil, I made some estimates of the price elasticity of oil supply and demand.

Since neither demand nor supply can respond instantly to changes in price, I first had to estimate the average reaction time. To do this, I looked at the correlation between changes in the oil price and changes in supply and demand with various lags. I used price and volume changes over a period of three years because three year changes gave me the strongest results, although one and two year changes were similar.

Below you can see the correlations between three year changes US and worldwide supply and demand with three year changes in US oil prices (WTI) and world oil prices (Brent), after various lags:

Note that we’re looking for negative correlation between price and demand (we use less oil when we have to pay more for it), and positive correlation between price and supply (companies produce more oil if they can get more money for it.)

From the chart, we can see that world oil supply has historically taken about one year to respond to changes in world prices (the blue line peaks at 40% correlation with a one year lag), while domestic US oil production (supply) has typically taken about four years to respond to changes in the oil price, but that response is much stronger than the response of world supply.

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Comments

I already agree that we’re headed for contraction, although I don’t think it’s inevitable. So much energy and so many resources are wasted in our economy, that there is still room to grow by eliminating waste. But using such efficiencies to manage a resource contraction would require a concerted effort to transform our economy by government, business, and individuals. Some businesses and a few individuals are making this effort, but not enough to avoid contraction.

But I think we’ll be surprised at just how many and how quickly efficiencies appear when the price signals really start to bite. I think the contraction will surprise us with its mildness, given the resource constraints which caused it.

Isn’t the end of elastic oil related to the peak in conventional oil supplies? With the smoke coming out of the oil and gas industry these days, one would be led to believe there is an endless supply. But the cost of oil and the desperate moves to open up new gas fields through fracking belies that notion. Looking at the behavior of oil and gas companies and their continued posturing to maintain a stranglehold over energy markets is disheartening. I would expect companies faced with increasingly difficult to access supplies, imminent climate change, increasing environmental shocks due to expansion into unconventional fuels, growing demand worldwide, and a depleting resource base that is causing economic instabilities and threats to the world food supply would provide more than token investment for transitioning to renewable energy. Instead, they’ve doubled down on their dirty, dangerous and depleting resources.

The underlying phenomena behind declining elasticity of supply and peaking oil supply are the same. The difference is that the moment when oil supply peaks has no real economic significane. On the other hand, changes in the elasticity of supply have great economic significance, and they began long before the peak and will continue after, becoming increasingly serious.

But it is related to depletion and demand destruction, correct? Depletion seems to cause the cost of new supply to rise (due to the ever increasing energy and resource cost to access the new supply). So, as you noted, the oil companies aren’t willing to take as much risk to produce unless they know the demand at the higher cost will be there. And, over time, in innovative economies, won’t the rising elasticity of demand make the oil supply more fragile/inelastic, not less? Wouldn’t these factors, over time, have a tendency to push oil supply against a wall?

My focus is on, in economic terms, increasing the elasticity of demand for oil. The best way to do this is to create an oil free transportation system in parallel – and reduce subsidies for oil consumption ($30 to $40 billion/yr for trucking#)

- Electrified and expanded railroads to take most truck freight. - Urban Rail – enough to meet the market demand for living in Transit Orientated Development (30% of Americans want to, about 2% do because there is simply not enough Transit to orientate development around) - Making bicycling safer and easier.